5 Diversified Treasury-Beating Dividend Collars

Despite reflation and quantitative easing moves by the Federal Reserve and the European Central Bank, somehow the bond market has failed to demand high yields to bear looming, immense interest rate (inflation) risk. Despite this risk, many investors seeking yield feel that they have no choice, and prefer the perception of safety provided by bonds.

Fortunately, the options markets provide opportunities to construct treasury-beating option strategies on dividend stocks. The simultaneous purchase of a stock, writing a call option, and buying a put option creates the option strategy known as a collar. This strategy has limited upside and downside, which if constructed carefully on the right stocks is more attractive than buying a treasury. Several dividend paying basic materials stocks were used to construct collars in a prior article, thereby providing a means to beat Treasury bond payouts. This procedure is extended in this article for a mix of five stocks which hail from different industries. The following criteria were taken into account for comparison with the 10-year treasury:

Higher yield. The options strategy must provide a higher yield than the 10-year treasury on the net initial investment. To this end, stocks were selected which have a higher dividend yield than the 1.87% bond equivalent yield of the 10-year treasury. Stocks were also screened for payout ratios at or below 0.50 to allow for dividend growth or slack in the event of a downturn.

Better upside potential. The option strategy must allow for more appreciation in the value of the total position than is available to the 10-year treasury. Based on the current rate, a 10-year treasury bond would appreciate 3.42% if its bond equivalent yield dropped to 1.5%. Thus, a superior option strategy must allow for a 3.42% appreciation in price.

Better downside protection. The put component of the strategy must limit the potential loss of the position to less than could be lost in the treasury if interest rates bump up to 5%. Based on the current rate, a 10-year treasury bond would drop 24.4% if its bond equivalent yield rose to 5%. There is the possibility of even more downside in treasuries from above-average inflation, but this is a good number to start with.

Sustainable dividend payments. The dividend paying stock must not payout more than 60% of earnings as dividends. If a stock had a much higher payout ratio, then declining earnings would be more likely to force companies to slash dividends. Moreover, retained earnings can be used to for reinvestment to grow earnings going forward.

The following five stocks were found to provide the right mix of dividend yield and available options to construct attractive collars:

The strategy of buying the stock, selling the call, and buying the put creates the following payouts and adjusted dividend yields:

Ticker

Position Net Cost

Max Value

% Gain

Min Value

% Loss

Adjusted Dividend

WAG

35.87

38

5.94%

32

-10.8%

3.06%

CVX

117.07

125

6.77%

100

-14.6%

3.07%

PEP

70.36

75

6.59%

60

-14.7%

3.05%

RTN

57.66

60

4.06%

52.5

-8.9%

3.47%

MCD

91.06

95

4.33%

82.5

-9.4%

3.07%

Click to enlarge

Consider the options strategy suggested for MCD. Instead of buying the stock alone for $91.70 and hoping that the stock price does not tumble, an investor could opt to create a collar.

The collar could be created through the purchase of MCD stock for $91.70, buying the put at $1.57, and selling the call at $2.21. The net cost of this position is $91.06, which is cheaper than buying the stock by itself. The benefit of the additional option trades is a floor on losses, which are limited to 9.4%. The yield on this position is 3.07% (annualized).

Each of these positions has less downside and more upside in capital appreciation than a 10-year treasury based on 5% to 1.5% interest rate scenarios. Furthermore, each of these stock collar positions provides a higher yield which could benefit from increases in dividend policy. Fixed income investors should consider these positions as attractive bond alternatives which they can use to supplement their income portfolios, reducing interest rate risk.

Disclaimer: This article was written to provide investor information and education, and should not be construed as investment advice. I have no idea what your individual risk, time-horizon, and tax circumstances are: please seek the personal advice of a financial planner. This article uses third-party data and may contain approximations and errors. Please check estimates and data for yourself before investing.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.